George Selgin of West Virginia University talks with EconTalk host Russ Roberts about free banking, where government treats banks as no different from other firms in the economy. Rather than rely on government guarantees to protect depositors (coupled with regulation), banks would compete with each other in offering security and return on deposits. Selgin draws on historical episodes of free banking, particularly in Scotland, to show that such a world need not be unduly hazardous or filled with bank runs. He also talks about Gresham's Law and an episode in British history when banks successfully issued their own currency.

Highlights

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0:36

Intro. What is free banking? Banking without any special regulations, conducted as it might be if government treated banks as they treated shoes or widgets or anything that is a real good. Government has regulated banks heavily in all countries. What role for government in free bank? No special role other than enforcement of contracts. If you had a commodity monetary base such as gold or silver, there might not be any need for special regulation. Most people's reaction is: Banking is too important to be left to the private sector. Lots of things are really important: trade, food, agriculture; hard to think of any sector of the economy that is not important. Does government involvement make it work better or not? Pre-1913, before the Federal Reserve, though not free banking, relatively free. Fraught with bank runs that we thought the Fed has learned to smooth (though rethinking lately). Several instances approximated the ideal of free banking. Most important thing is that creation of the Federal Reserve did not mark the beginning of government interference with money and banks. In the United States, government has wielded a very heavy hand. Before the establishment of the Fed, lack of branch banking--which remained true for many decades after the establishment of the Fed; and banks were restricted in their ability to issue currency. Those two regulations created all kinds of trouble with the pre-Fed monetary system.

6:09

Branch banking and currency issuance. Under free banking, would banks be the only suppliers of currency or merely the holders of deposits of government money? Today banks issue a lot of people's money holdings in the form of various kinds of deposits. Until recent times, banks were the only suppliers of any kinds of money. Pre-Fed times, pretty much banks and mints supplying money. Banks could issue their own circulating notes. The brands issued by different banks weren't truly distinct underlying monies. Different banks issued $1 notes, $5 notes, etc., but they were all claims to some underlying amount of gold. Uniform monetary standard, but no monopoly on the issuance of the paper. Stopped in two stages. During the Civil War, the state-chartered banks, which were the only kinds of banks that had existed at the time of the outbreak were deprived of the right by subjecting them to a stiff tax. Before that took effect another kind of bank was established--National Banks under Federal charter--and those continued to issue their own notes, but had to back them more than fully with government securities, to help finance the Civil War. Didn't have anything to do with improving the performance of the monetary system. As the government retired its debt, it became exceedingly costly for them to supply currency, so currency supply shrank; set stage for financial crises into the early 20th century. Argument for establishing the Fed: Let's set up 12 banks that can issue currency when the laws prevent the national banks and state banks from doing it. New set of banks not subject to the same rules. Problem was these banks could issue too much currency, and did so. If private sector created the roads, we'd have roads going everywhere--like we have now? If all currency were issued privately, would currency issuers have an incentive to inflate the currency? Just like the government does. If all currency were privately issued, what would be the protection for holders from inflationary pressure? Today if the bank makes too many loans (holding available stock of Fed-supplied reserved constant), no bank can go too far in making loans because checks are drawn on those loans, get redeposited and cleared, so a bank that is being too generous is running out of reserves. Puts strict limit on money creation in the form of deposits. Same discipline historically. Rival banks sent notes back for redemption. Doesn't work if you give one bank a monopoly because its notes are treated as reserves. Restraint in the private system. Suppose a bank makes too many loans, putting out too many bank notes. They circulate and get turned in naturally to my rivals. Rivals come to me looking for gold. If I've issued too many, I run out of gold. What protects the holders of my notes? They will continue to accept your notes as long as they believe you are behaving responsibly. What will usually happen if a bank gets a reputation for lending too aggressively, the clearing house will probably catch on before anyone else and throw that bank out; and then other banks won't accept its notes. Historical incident: Ayre Bank, Scottish bank pursued an easy money policy and was issuing too many notes; quickly discredited and Ayre Bank collapsed in fairly short order. Depositors suffered, but most of the losses were suffered by the bank owners, of which Adam Smith was one. Clearing system disciplines banks and keeps them from going overboard because they know what they can expect.

15:40

Banks vs. other businesses. Car manufacturer cheats on quality of the car --some get stuck with mediocre car, but most of the losses are borne by the stockholders who lose future benefits. With banking, you are going to wipe out people's savings. In such a world, would not people be uneasy putting any significant sum of money in any one bank, instead spreading them across many banks? Or would there be insurance of some kind? That's what bank capital is for. Front line of defense of the banks is their capital. Put your money in a bank that's got a lot of capital. Any losses it suffers as a result of bad loans come out of that capital. If it overissues, it will suffer reserve losses and a liquidity problem that should constrain it very quickly. If it makes bad loans, lack of solvency, comes out of capital; only after capital exhausted do depositors and note holders suffer. In whole Scottish free banking history until 1845, total losses of those who held Scottish bank notes were minuscule compared to losses borne by taxpayers as a result of bank failures in modern times. Capital suppliers like Adam Smith bore the losses. Feedback loops: if car doesn't run well or falls apart quickly, word of mouth spreads information. Hard to see how that would work with free banking. Would get signals much faster than with car maker. Notes are assets, traded in secondary market; the minute there is any doubt about the value of a bank's balance sheet, solvency, its notes are going to trade at a discount. Generally notes stay at par. Which of all these banks do I consider worthy of having my money? Individuals have an incentive to do some research, into its capital; will want to put as much effort into choosing a bank as into buying a car--which today nobody does for banks because of deposit insurance. Next, will want to ask: What notes and checks of other banks is my bank willing to take? If your bank accepts them, you can safely accept them. Usually same as group within clearinghouse. Banks not in good standing get weeded out or couldn't get started in the first place.

21:17

Would there be fractional reserve banking in a free banking system? Yes. Going back to the Scottish case, about 1820, not a lot of modern devices; typical Scottish bank held gold reserves of 1-2%, in an arrangement where everybody had the right in principle to convert a Scottish bank note into Scottish gold. Such was the faith in the banks that nobody every did it, which is why the reserves were so low. Quote: The first thing anyone in Scotland would do if someone paid him a gold guinea would be to get rid of it quick by depositing it in a Scottish bank and receive paper. So, only 1-2% could show up at a time, though they didn't. Bank run: if depositors did lose confidence, there wouldn't be enough. How do banks in a free reserve system do in that kind of system? Do they have to shut down? Remember that the 1-2% figure evolved through trial and error. If there had been a run and banks had no other recourse, they'd have to shut down as soon as they ran out of gold reserves. However, that doesn't mean that remaining depositors would get nothing. Bank would be liquidated and assets and capital used; often would be a complete payout to depositors. Recourse the banks themselves had until a law was passed preventing them from using it was called the Option or Optional Clause, that banks put on their notes. Clause said they reserved the right to suspend payment on notes and gold, but if they exercised it, then during the period of suspension they had pay the maximum allowed rate of interest of 5% to the note-holder. Note gets converted to a little bond. Note raids used by rival banks against each other were the only occasion of using this Clause, not runs from their own customers. Would have been a useful device had a run happened, but one never really happened. Problem as an insurance system--many such private contractual arrangements in today's economy--if a bank was profligate and made bad loans, the likelihood that the assets would cover the costs is even smaller because of the delay. Beauty of the Optional Clause: if designed right with proper rate of interest, incentive-compatible. The only time it would pay for a bank to use the Option Clause instead of winding up, going bankrupt, would be if in fact it was solvent, and people were panicking even though nothing was wrong--pure panic, imperfect information. If a bank has instead been profligate, it doesn't pay to invoke the Clause--simply shut down. But the shut-down would be disastrous for the depositors. If you do business with a profligate bank, you do badly. Could be a takeover. Bottom line is, a bank customer faces a positive probability of losing your money. Every government scheme for trying to do away with that aspect of free banking has ultimately given rise to a less safe system of banking in which though the depositors don't face losses, the taxpayers do. Losses become systemic.

29:55

In a free banking system, mid-18th century to 1845, in that world, what is restraining the bank from opportunistic behavior? Loss of reputation and ability to run their bank? Loss of capital. Many had unlimited liability, so owners' personal property was exposed. Common before the Fed to have capital that was 30% of liabilities. Central Banks are substitutes for capital in the eyes of depositors--if you have a lender of last resort you don't need that kind of capital. That's why bank capital has to be regulated today--we've gotten rid of all the natural incentives for depositors to insist that they do. Why do we think that the Scottish "experiment" was killed? What happened was the careless extension of legislation adopted for England being extended to Scotland. Peale's Act; England had a central bank, subjected currency component of the money stock to strict limits. Implemented by trying to impose strict limits on the note issue of the Bank of England; and also capped the note issues of other banks and made them subject to 100% reserve requirements. Gave Bank of England complete monopoly and didn't solve the problems. Extended to Scottish banks. That's why today there are only two Scottish banks of issue whose notes outstanding at least until the recent crisis have still been at the upper limits set by Peale's Act.

34:17

Is ideal a decentralized both banking system and money supply? In such a world, what would business cycles or inflation look like? Two things at stake. One, what sort of banks do we want to have? Need a system where banks can fail and customers take losses, because if you don't do that there will be a strong tendency to have only lousy banks. Macroeconomic question: how will money supply behave and will there be fewer or more business cycles? Reason for talking about free banking isn't just because of "freedom" or being libertarian. Want theory of free banking. No country with perfect free trade, but we have an understanding of what tariffs do comes from theorizing about free trade. Most monetary economists don't have a conception of what a free banking system looks like. You can only say what a Central Bank is doing if you have an underlying notion of what the system looks like before the Central Bank gets created. No alternative in most people's minds to the Central Bank regulating the money supply. Milton Friedman, fixed growth rate in high powered money. Until about 6 months ago, most people would have said we've got the hang of this Central Bank thing, 25 years of more or less steady growth, two small recessions. Current mess, not clear it indicts that viewpoint. Counterpoint to Central Banks being necessary. Statement presumes some knowledge of what Central Banks would do. Performance of Central Banks at best was not great. Inflation rates were generally above 2%; there were cycles. To pick on a 10-year interval and ignore the many decades in which Central Banks have screwed things up is biased. But we had to figure things out! Current crisis proves that wrong. Central Bank played an important role in pumping up the housing bubble. What looked like a period of stability really wasn't, just setting the stage for a cycle.

41:05

Inevitably the rule of human beings rather than rule of law. Greenspan worried about 9/11 and about the tech crisis went too far; Bernanke, when deciding to bail out Bear Sterns did that in an effort to avoid recession but may have hastened it. What's alternative theory of what business cycles and inflation would look like under free banking? Have to specify the standard--gold standard, silver standard, even fiat dollar created by a Central Bank. Wouldn't need to have an activist Fed. The Fed monopolizes only currency. The Fed's control of that one component gives it leverage over the whole stock. Can't shut down its operations without there being a mismatch of supply and demand. If you allowed banks complete freedom you could simply freeze the monetary base--just keep that stock constant. Need adjustments for currency flowing in from abroad, redeposits in banks. What you really want to freeze is supply of bank reserves. Imagine that the system has evolved so that no more green pieces of paper in circulation, just liabilities in the form of reserve credits. Two forms: Federal reserve notes, dollar bills, about half of which is abroad; rest of monetary base is monetary reserve credits, claims against the Federal Reserve on the Fed's books. Fed is the banker's bank. Bank puts money at the bank; deposit entry at the Fed. Freeze the total of that. Banks can supply the paper currency that people need. The frozen base won't be a problem. Changing needs of the public can be accommodated by the system. Falling price level if productivity positive. Less-than-zero argument. If public wants to accumulate more money and stops spending, don't draw as many checks or pass on their bank notes, decline in the velocity of money, would be a tendency for banks to issue more money, make more loans; their demand for reserves is a function of the flow of payments through the clearing system. When flow goes down, banks can bring it back up again by lending more. Changes in velocity get offset by money stock. Theory of Free Banking, first book. Why is there a Fed at all? Are we going to keep the Fed? Only if we want to keep the dollar rather than transition to a gold standard. Fed's role could be nothing more than a maintenance institution, no discretionary power. Strip it of open market operations and discount window; all done by private sector. Get rid of FDIC; could privatize the Fed clearing system. Get rid of the reserve requirements so reserve ratio can be flexible. Banks can also go bankrupt. How will whole system behave? In principle, total money supply adjusts: if people spend less of a bank's liabilities, the bank can afford to offer more. Stream of reserves. Precautionary balances: bank can inject more into the stream because the money isn't going to translate into more reserve losses. If people write checks every week and suddenly stop, bank can expand forever, because no one is going to draw on it.

52:01

Would we have a business cycle? One of the things everyone agrees contributes to business cycles today is swings in demand for goods, aggregate demand. If you have too much spending, it can contribute to a bubble. If you have a collapse of spending, you can get a recession. Maintaining a fairly stable level of spending is important to dampening the business cycle. You want to have a money stock grows when velocity of money goes down and vice versa. That's just what happens in a free banking system. Taylor Rule was thought to do the same thing. What has that failed? A lot of these rules look at the price level as a proximate signal of whether there is too much money or too little--can be misleading. Look instead at total spending. More or less equivalent if you hold productivity constant. Think of the equation of exchange: MV=PY. (M=money; P=average price level; Y=output; V=rate it turns over, called the "velocity of money".) What you really want is to stabilize PY, or equivalently MV. If you stabilize MV, you are stabilizing PY, but you are only stabilizing P itself if Y is unchanging. If you have a change in output due to productivity improvements, which you hope for, and want to stabilize spending, then you want the price level to fall; and to rise if productivity suffered a setback. Want to stabilize the aggregate demand schedule, but if the aggregate supply schedule changes you let it bounce around. The price level measures prices of finished goods. If more output for any given input, you've got a big relative price that has to change. If you stabilize the output price level, you've got to inflate input prices.

57:12

Political economy: government likes having control over the money supply. One argument is that we need the government's hand on the tiller to stabilize things. Doesn't look so good in practice, but could justify it by things that are outside the monetary authority's control. Some monetary institutions are looking less attractive than they once did. Governments want to move in the direction of insurance guarantee and no risk, which can't be done. Or is there something more sinister going on? private benefits from controlling the money supply? Lack of faith or public choice issues? Most people believe you have to have control of the monetary system or all hell would break loose. Many interests at stake which would suffer from a move toward free banking. Central banking creates interest groups that lobby for or against inflation or deflation or stabilizing policies. Pressure to inflate from certain groups including debtors the value of whose debts would decline. Latest book, Good Money--historical episode. No longer talking about banks. Bank of England existed in late 18th century. Money in those days consisted of coins, silver or copper, for all but the well-to-do. Also have the Industrial Revolution happening, rapidly increasing the need for these coins for retail and wage payments. Supply: Royal Mint, agency charged with creating those coins, was producing no silver coins and practically no copper coins. Result was change shortage, money shortage, which became extremely severe, threatening to undo a big part of the process of the Industrial Revolution. Merchants had trouble to pay their workers or make change to accomplish sales. Necessity is the mother of invention: a couple of entrepreneurs who had interests in copper mining tried to persuade the government to do something about the coinage by commissioning more which they offered to do by minting coins. Proposals fell on deaf ears. Thomas Williams, one of the entrepreneurs, set up a mint and minted coins bearing his mark. Later, John Wilkinson put his own bust on the coins. The coins' makers didn't run into the problems the Royal Mint had run into, such as counterfeiting and distribution problems. Coins initially were actually heavier than Royal Mint; beautifully engraved, redeemable on demand. In all respects superior money than Royal Mint. Solved the shortage. Why did it come to an end? First ended after 1797 when in a reaction to the suspension of the Bank of England the government finally supplied more coins. New coins didn't solve the problem though because the lack of competition caused these coins to not satisfy demand. New shortages, another outbreak of private coinage after 1810. That episode included silver coins, because Bank of England had been doing that; and then finally someone issued private gold coins. That was viewed as a threat to the Bank of England's sovereignty.

1:08:27

Gresham's Law: bad money drives out good. Why didn't that happen during that episode? Named for Thomas Gresham, Elizabethan financier. All refer to situations where there was no private coinage, no free choice in coinage, but a government monopoly that decided to dilute the quality of its coins, usually by making coins with less precious metal in them. Punished people if they tried to discriminate between new coins--bad money--and old coins--good money. As a seller, you price goods as if you are going to be paid in the bad coin, because otherwise you take an unnecessary loss. As the buyer, you only pay in bad coins. So good coins tend to disappear. In free banking there is no tendency for that to happen at all. If no legal tender law, seller can choose. No Gresham's Law tendency. Under competition, good money drives bad money out. France; U.S. Revolution. France: paper assignats not treated the same. Legal for a merchant to ask in what medium he would be paid before quoting a price and making a deal.

It might be helpful to look at private income funds in the US as an example of unregulated banks. A typical private fund:
- Takes investments with limitations on withdrawal to avoid runs on the bank, but otherwise allows investors to withdraw money at regular intervals.
- Pay out interest income to investors regularly.
- Make loans using fund capital and profit on the difference between their loan rates and payout rates, or on the fees they charge.
- Pay different rates of return to investors depending on the risk profile of their loans.

These funds regularly fail every 10 years or so (assets + reserves fall below capital contributions) depending on the type of loans they make and economic conditions. Either they stop distributions, work out the portfolio and distribute the remaining capital or they go into bankruptcy and a judge does that for them.

Both these types of funds and regulated banks suffer from agency risk and a "race to the bottom" for bad loans. In both banks and funds, managers are motivated to maximize the profit of the banking company by increasing risk, some of which is borne by depositors. Because management is typically compensated based on short term performance, this misalignment of interests is very difficult to eliminate. Also, earnings per share are easy for investors to compare, whereas long-tail risks are hard to quantify and communicate in public filings, so stockholders tend to reward management teams that take too much risk.

How would free banking deal with this inherent instability? It doesn't appear to be fixed in the private lending world.

EconTalk's interview with George Selgin is one of the most though-provoking in its series so far.

PK's comments are spot-on. Any financial institution risks getting caught up in the deteriorating industry-wide underwriting of a credit cycle. Not only is it a function of misaligned incentives for shareholders & management, but it's also a function of the need to feed an established distribution infrastructure. Big financial services companies can't cut off their sales forces (independent or captive) for fear of losing them.

Warren Buffett experienced the extremes of this with Berkshire Hathaway & General RE (both reinsurance companies).

Berkshire Hathaway consistently withdrew from soft markets, because premiums weren't high enough. It would aggressively dive back in when it could get top dollar. Consequently, it would be very profitable, though those profits would be very lumpy. Also, GEICO (another Berkshire Hathaway company) could exit bad markets, because it wasn't beholden to any agents (it sells insurance direct to the public).

I just wanted to let you know that you're getting great at this. Everytime I hear someone speak elsewhere and think they would make for a great EconTalk podcast *boom* they're on the show within a couple of weeks. I really, really look forward to listening to this show. Thanks!

Congratulations, Russ, on having selected another thought-provoking and articulate speaker. Most of us have never given a second thought to the idea that the 'modern' model of banking was in some sense the optimal one because all the others had disappeared. Now I know that in fact they have been legislated out of existence.

It is interesting that a international, unregulated bank-like institutions like e-gold have had concerted international attempts to close them down. Politicians everywhere crave power and, as a result, are profoundly hostile to the idea of free banking.

Finally, someone understands banking under a gold standard and the role that depositors are supposed to play in a banking system.

pk: "It might be helpful to look at private income funds in the US as an example of unregulated banks."

These funds are not like banks, because they only lend their deposits. Banks don't lend deposits. Banks extend credit. Extending credit is not equivalent to lending deposits. Depositors in a bank only police the lending. They don't provide the bank's capital. Borrowers provide a bank's capital, i.e. the borrowers inform the bank of its opportunity to extend credit for the purchase of a valuable asset, credit secured by the asset.

A bank writing a mortgage simply provides a service to the seller of the house, so the seller gets cash upfront and does not bear the cost of extending the credit himself. The seller could extend the credit himself, but he outsources this business to the bank.

If depositors don't police banks, if they can't lose their deposits when a bank overextends credit, the depositors serve no useful purpose in a banking system at all. In a banking system like the U.S. system, we'd be better off without any depositors, because the depositors are only rent seekers constantly demanding that government bail out the failing banks.

Interesting discussion. Though I wished you would have gone into the ramifications of banks using different standards in a market. Such as, one bank would use the gold standard, another would use fiat money and so forth. What effect would this have, if any, in a free banking system? That scenario seems plausible in an open market where different banks from different nations may adhere to different standards.

Martin Brock "In a banking system like the U.S. system, we'd be better off without any depositors, because the depositors are only rent seekers constantly demanding that government bail out the failing banks."

By "bail out the failing banks." is that simply a reference to FDIC insurance? I am slightly confused as during the last bank bail out it seemed that depositors were against the bail out?

Yes, I referred to the FDIC for example, but I don't really agree that depositors opposed the recent bailouts. Many people, including me, opposed the bailouts, but most of these people didn't perceive themselves as depositors at risk, because their bank deposits are below the FDIC limit. So people opposed the bailouts but not as depositors.

Tell these people that their bank account balances are falling, and they'll sing a different tune. I'd still oppose the bailouts in principle, but I'd probably bow my head and single a barely audible protest while watching with relief as my account balance rose with the louder chorus. That's just human nature.

The latest bailout isn't about depositors as much as it's about bank capital, so depositors aren't the only interests clamoring for bailouts. Bank shareholders, corporate officers and other interests also clamor for them.

Still, my point is that depositors serve only one useful purpose in a banking system, policing banks overextending credit by withdrawing their deposits when they fear loss. If they don't serve this purpose, they don't serve any purpose.

Real investment is not a vending machine in which I deposit a dollar today and receive a dollar and five cents a year from now, without any meaningful exposure to the inevitable risks involved in real extensions of credit. I don't want able people simply entitled to consume without producing after depositing spare cash with some state agency. That's not the "capitalism" I'm signing up for. If that's the formula, I might as well be a socialist.

Great podcast, This subject really pushed the limits of my understanding. Dr. Selgin's understanding of the natural push backs of the bank markets in the past was quite beautiful given all the current pushing around the margins today.

Thanks Russ for going with what for me was difficult to understand subject, it is good to shoot for new perspectives and you did it well as always.

I want to thank Russ Roberts for these programs. A friend of mine was refering to EconTalk on his blog. It was the webcast about "War, trade and wine". I downloaded it to my mp3 player so I could listen to it when I went to work.
Now I have listened to about 10 of the podcats. I must say I really like tese talks even when I am not very interested in the subject as such since there are lots of things I learn about economic, political and philosofical questions.
Instead of listening to music listen to EconTalk which is much more educating.
Many thanks and keep up this good work. You have a big fan in Sweden now.

It's hard to see any benefit of this in the real world. Did I miss something here? Some small chance that inflation will be lower verses a larger chance that my bank goes bust at any time? With our current system I don't have to worry about whether my money will be there in the morning, and I can focus on other reasons to choose a bank: its service, location, ease of use. As a small business owner, I don't need more tasks on my agenda, particularly not continually monitoring the state of my bank.

Also, in a pure free market, wouldn't there be a tendency towards monopoly? People would want to choose a bank based on their faith in it's continued existence - I foresee a Microsoft of banking emerging very soon, without any check on its behavior. Such a bank would be able to buy up its rivals as they appear. What would stop a monopoly from emerging?

I guess this is an interesting idea, but like seasteading, it doesn't pass any kind of "who wants to do this" test. If the economy was an automobile, the banking system would be the oil in the engine: not something you want to be experimenting with. It's fine to let non essential features, like the air conditioner or the cupholders, be subject to a pure free market. Banks aren't non-essential, and should be subject to regulation.

Selgin and Roberts were both at a loss to name a country where the free market is truly free -- operating without any government regulation whatsoever. Yet there is such a country: Somalia. Wonderful place, if you're a freemarketeer. Or a pirate.

I enjoyed this podcast because the person being interviewed did a good job explaining a banking system where there was no central bank. I have also come to realize that the central bankers probably have a lot less control than they think.

Central bankers can't "regulate the economy". The whole idea of a central bank "regulating the economy" is why central banks gum up the works.

A central bank lends to member banks and requires member banks to repay its loans. When a member bank fails to repay its debts to the central bank, the central bank takes possession of the member bank's assets (primarily the still performing loans) and auctions them off to other banks.

Proceeds of the sale pay bank depositors first, and bank shareholders get what's left if anything. Bank officers and other bank employees lose their jobs and go looking for work, possibly at the other banks buying the assets.

New banks appear continuously. Anyone satisfying reasonable entry criteria may enter the business at any time and starting extending credit by borrowing from the central bank. A new bank entering the business might buy assets from an insolvent bank.

The principal role of the central bank involves establishing rules of the game, reserve requirements, its interest rate and the like. The interest rate charged member banks by the central bank is nominal. The central bank is a "bank" in name only. It's actually a bank regulator, a monetary authority.

If the central bank does its job of effectively regulating and quickly liquidating insolvent banks, it can charge member banks on percent and never change this rate. Member banks obviously charge a rates based on their perception of the risk of extending credit. These higher rates have nothing to do with the rate set by the central bank, except that they're necessarily higher.

End of story. That the story does not end here is the problem. Favoring large, established banks and continually bailing out banks, so Paul never worries about losing his deposits and bank shareholders don't lose their investments and bank employees don't lose their jobs, is why the system doesn't work.

"Selgin and Roberts were both at a loss to name a country where the free market is truly free -- operating without any government regulation whatsoever. Yet there is such a country: Somalia. Wonderful place, if you're a freemarketeer. Or a pirate."

I think you misunderstand what a free market is. It's a system where property rights are exchanged voluntarily (without force or fraud). Since exchanges with the government are not voluntary, you're right, free marketeers are against most government activity. But gangs of pirates or thieves violate free market principles just as much as governments. So if there are more involuntary exchanges under Somalian anarchy than in American democracy, then it is LESS of a free market.

Paul Downs wrote:
"It's hard to see any benefit of this in the real world."

The usefulness is to understand the real world that does not have free banking. As Selgin points out during the podcast, we understand the consequences of tariffs and taxes by referencing to a free-market system, whereas we don't do that in Monetary theory. This makes it difficult to understand what the Fed, FDIC, etc is actually accomplishing.

"As a small business owner, I don't need more tasks on my agenda, particularly not continually monitoring the state of my bank."

Indeed, most people would not, but banks would compete to attract those who do engage in heavy monitoring. In short, since banks can't separate the monitors from the non-monitors, those heavy monitors create positive externalities for us free-riders.

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